Years ago, just after the fall of the Iron Curtain, a joke was making the rounds regarding a recent immigrant from a former communist nation who walks into his first American shoe store to buy a pair of shoes. Citizens of communist nations had grown accustomed to a limited supply of all basic goods and services. This new immigrant was no different. He had grown up in a world where you were lucky to even find a pair of shoes in your exact size, much less a selection of them. Now, as he surveyed the vast array of choices available to him, he became increasingly exasperated. Finally, he turned to leave without making a purchase.
"Didn't we have anything you liked?" asked the salesman.
"That's the problem," exclaimed the immigrant, "There are so many choices I'm too confused to make a decision!"
Investors today have vastly more investment choices than ever before. Yet, despite this wealth of available options, investors continue to struggle. Could it be that the flood of products, vendors and account alternatives is actually making the investment decision process more difficult? Are there ways to simplify your approach and still succeed?
Starting With the Proper Perspective
There seems to be a prevailing misconception that one can quickly "invest" his or her way to a fortune. Throughout history, only a rare few individuals have accomplished this feat and even they typically took on vastly more risk than the average investor could tolerate. Finding the next Microsoft (Nasdaq:MSFT) or day trading your way to wealth is not the mindset one should have when approaching the investment landscape.
As a general rule, you will generate substantially more income and wealth-building potential from your job than you ever will from investing. Wealth is created over time by saving part of this generated income. With a generous income and a disciplined saving habit, a material amount of wealth can be accumulated over an extended period, even if that wealth is invested in nothing more than a traditional bank savings account. Enlightened investors, however, recognize that they can expand the growth of net worth by investing accumulated savings in other assets with greater growth potential.
Different Packaging, Similar Contents
Tax laws generate a great deal of unnecessary complexity for the average investor. A number of products and account structures are created to take advantage of tax policy, including variable annuities, IRAs and 401(k)s, to name just a few. Keep in mind, however, that the government rarely gives away anything for free. Capital gains in a taxable account are taxed at lower capital gains tax rates when realized. Those same capital gains are taxed at higher income tax rates when realized and withdrawn from a variable annuity or IRA. These accounts may make sense in many instances, but in other instances they may not be the best alternative.
Financial firms, recognizing that they are all fishing from essentially the same asset ponds, seek to attract clients by finding different ways to combine and package investment assets. As a result, thousands of mutual funds exist today that are essentially just different combinations and packaging of the same stocks and/or bonds. The result of all these multiple account structures and packaging options is that investors often accumulate investments in a hodge-podge manner over time.
Owning several different investments can often mean that little thought is given to how these various parts work in concert with one another. In addition, there is typically no way to discern how they are performing in the aggregate. The task of keeping track of the many statements and assorted paperwork becomes a logistical nightmare for investors and their tax advisors. As a result, investors start looking at the individual accounts and investments as separate parts rather than one, concerted investment portfolio. This is known as "mental accounting" in the behavioral finance world, and it can be detrimental to your long-term investment success. It would be far better to employ a more simplified approach.
The Impact of Asset Class
Despite all of the many different ways they are packaged, investments largely contain one or more of just a few asset classes. These asset classes include stocks, bonds, cash (or cash alternatives), or physical assets like land, real estate, precious metals and commodities. Other, more complex investment alternatives are based on these underlying assets. Derivatives derive their value from some asset. Options give you the option to buy or sell an asset at a particular price and at a particular time. Futures give you the right to deliver or take delivery of some asset at some set price and at some set point in the future.
The more exotic investment alternatives serve their purposes in certain settings, but you do not need to use them. In fact, you can create an effective investment strategy by sticking to the asset classes with which you may be most familiar - stocks, bonds and cash. The world of investing can be immensely complex, but you can build significant wealth over time without ever getting involved in the esoteric areas of investing.
In the July/August 1986 issue of the Financial Analysts Journal, a study by Brinson, Hood and Beebower entitled "Determinants of Portfolio Performance" concluded that 93.6% of the variation of returns in a diversified portfolio is explained by the asset allocation policy. While this study has since been the subject of some questioning and has no doubt been somewhat distorted by various marketing materials within the financial services industry, the disproportionate impact of asset class exposure on the return and volatility of a properly diversified portfolio appears evident.
Different asset classes have demonstrated certain performance characteristics over time. No one can predict the future, but a basic knowledge of how these asset classes have tended to perform and how they relate with one another will go a long way in helping you establish a long-term investment strategy that stands a chance of meeting your goals and objectives.
The Bottom Line
A simple and straightforward approach can be employed by anyone who wants to establish and maintain an effective long-term investment strategy. First, keep the proper perspective. Do not attempt to get rich quick. In other words, keep your day job! Second, keep accounts and product selection to a minimum. Finally, focus on asset class selection and the overall asset allocation of your entire portfolio, making sure that your asset class exposure is fully diversified. As you can see, your approach does not have to be overly complicated, it does not have to be time consuming, and it does not require a vast array of products or accounts. In the end, you may actually find that less is more.